Investing Without Blinders
At first glance, Robert Arnott doesn't come across as a rebel. The 49-year-old portfolio manager of the PIMCO All Asset Fund is a by-the-numbers guy -- a "quant" who wears dark suits, works 11-hour days, and edits the Financial Analysts Journal just for fun. But he has also been riding motorcycles à la James Dean since he was 16. "In a car, you're in this metal cocoon," he says. "On a motorcycle, there's a wonderful feeling of freedom, of being part of the world around you."
Arnott thinks most investors are also trapped in a cocoon, one that limits them to buying conventional stocks and bonds. Stocks, he argues, are still overpriced. "I believe that stock prices, adjusted for inflation, will be lower 15 years from now," he says. He also thinks yields on most government and corporate bonds are too skimpy. Instead, he invests in more unusual asset classes, such as emerging-markets debt, commodities, and his current favorite, Treasury Inflation-Protected Securities (TIPS). And his fund, like his Brough Superior SS-100 motorcycle, is free to explore such obscure regions.
Arnott has an impressive track record. His Pasadena (Calif.) money management firm, First Quadrant, runs $13 billion in private accounts for high-net-worth and institutional clients, including an account for a sovereign government, which he cannot disclose. All eight of First Quadrant's investment strategies have beaten their benchmarks since the firm's founding in 1985. The PIMCO fund is his first foray into mutual funds, and while it borrows from his firm's strategies, it is unique. Since its inception a year ago, the fund is up 18.5%.
Arnott's analysis of TIPS is unorthodox. These securities, issued by the U.S. Treasury, appreciate along with the inflation rate, plus they pay interest on top of that, historically ranging between 2% and 5%. Most published research on TIPS compares them with Treasury bonds. Arnott contends they are more akin to stocks. The reason is that the revenues and earnings of most companies are correlated with the inflation rate, growing when prices of goods and services rise and shrinking when they fall. And stock prices typically follow earnings growth.
A CLASS BY ITSELF
Conventional Treasury bonds, on the other hand, are at the mercy of inflation because their rates are fixed. So if inflation rises, Treasuries' "real yield" -- their return above the inflation rate -- declines, while the real yield of TIPS stays put. That, he argues, makes TIPS a different asset class altogether. Still, even compared with Treasury bonds, they look cheap. Long-term TIPS, with maturities of 25 years, now have a real yield of 2.8%, while the average real yield on long Treasury bonds has been 1.9% historically. Arnott thinks the "fair yield" for TIPS is 1.5% because there's no inflation risk. If he's right, prices for TIPS should rally.
Relative to stocks, though, TIPS look spectacular. Currently, the dividend yield on the average stock in the Standard & Poor's 500-stock index is 1.7% -- on the low end of its historical range. The average price-earnings ratio, based on S&P stocks' current prices and trailing 10-year average earnings, is 28. And the "e" portion of that p-e ratio, Arnott contends, is overstated by as much as 40% because of the accounting shenanigans of the past decade. But what about more financial disclosure and expensing of options? That, he says, will make earnings in the future look even worse.
What's more, stocks have demographic trends working against them. "The first of the baby boomers start retiring in about five years," says Arnott. "Most likely, they will sell their riskiest assets first." Since stocks are more volatile than bonds and TIPS, they will be first to go.
Arnott will still ride a rally when he spots an opportunity. For instance, last October he had 20% of his portfolio in stocks as interest rates reached a point where stocks became more attractive than bonds. Lately, he has been selling stocks as rates have backed up: His weighting is just 7% now. Arnott doesn't pick stocks for the All Asset fund. Instead, it invests in the PIMCO Stocks- PLUS and PIMCO StocksPLUS Total Return funds. In fact, for all investments, Arnott employs other PIMCO mutual funds.
One of the more unusual asset classes Arnott uses is commodity-linked bonds. Only two other mutual funds, PIMCO Commodity Real Return Strategy and Oppenheimer Real Asset Fund, invest in these securities. Their returns are directly linked to the prices for such commodities as oil, natural gas, cattle, and corn. That makes them better inflation hedges than the stocks of producers, which often react more to stock market moves than to commodity prices. Arnott's commodity weighting rose as high as 20% before the U.S. war against Iraq, but it has since come down to 7%. He thinks the sector will take a breather until inflation kicks in.
That's why 57% of All Asset's portfolio is invested in two PIMCO TIPS funds. That has hurt returns recently because TIPS have fallen with Treasury bonds as interest rates backed up. "We have an Administration pursuing a highly inflationary fiscal policy, and a Fed with a highly inflationary monetary policy," says Arnott. Such policies justify a sell-off in Treasuries, he says, but not in TIPS. "I'm glad there are people who believe TIPS are like Treasuries," he says. "They create buying opportunities." Let them live in their cocoon. Arnott's fund will zig when everybody else zags.
By Lewis Braham